The 4 Biggest Risks that Threaten Home Prices Today

I’m a big believer in trying to understand the risks in any investment I make. There are always going to be unforeseen risks — like a war, a terrorist attack or a crazy natural disaster — but the more risks you can plan ahead for, the better off you are going to be.

Here are the biggest risks I see for single-family home prices:

The 4 Biggest Risks that Threaten Single-Family Home Prices

1. Tightening Lending Standards

I am generally for the tightening of lending standards as prices increase and the loosening of standards as prices decline.

The lending community has been doing it the opposite way for a while now. When prices are dropping, it means that homes should hypothetically be more affordable — and vice-versa when home prices are increasing. Obviously it depends largely on wages, but that is a separate topic. My point is that tightening lending standards pose a real risk for current single-family home prices.

In many areas housing prices have been buoyed by “all-cash” buyers or investor types. This is true of markets like Atlanta, Phoenix, Vegas and Florida. These people are somewhat indifferent to lending standards — or at least were for the past few years.

At some point home prices will reach a point where it no longer makes sense for investors. The new buyers are going to have to get loans. If lending standards are tightened, then this could have an adverse effect on prices.

2. The Failure of the Buy-to-Rent Funds

I have dealt with a lot of large funds that bought thousands of homes with the intention of fixing them up and then renting them out. The jury is still out as to whether this strategy will work in a sustainable way. Operations for many of these companies still need a lot of work, and it is much more difficult to operate 1,000 homes over a wider geographic area than it is to operate 1,000 apartment units in a few complexes.

The latest strategy by some of these funds has been to create a rental yield bond. In other words, they are packaging together a number of homes that are rented and selling investors the right to a fixed portion of the rental income. It may sound similar to what banks did with mortgage backed securities.

There simply isn’t enough data about single-family rental tenants to determine the risk profile for these bonds. Are tenants in Atlanta more like to default than those in the San Francisco Bay Area? At what price point do delinquencies become more prevalent? How are evictions and ongoing capital expenses paid for? And these are just some of the questions that need to be answered.

To the point, if these funds fail, then they are likely to start selling some homes. I know that large funds like Colony Capital and Waypoint Homes are already selling parts of their portfolios. Right now it is small, but if these companies are forced to sell much larger portions, it could flood the market with supply.

3. Student Debt

I have been seeing a lot of headlines about student debt lately. Notably, Mark Cuban commented on it in this article. The effect on the overall economy could be substantial, but the effect on the housing market could be even worse.

The US Census Bureau estimated that almost one million housing starts took place in 2013. A million homes. Who is going to buy them if young Americans are saddled with thousands of dollars of student loans?

It is possible that those people who have rented for a long time will end up buying a portion of them, but what does that do to the funds who are dependent on high rental prices? During the recession new construction essentially vanished, which put upward pressure on home prices and also rents.

The problem is that with more construction comes more supply. If students are unable or unwilling to get home loans because of student debt, it doesn’t take a genius to see what it will do to pricing.

4. The Fed Stops Dumping Cash from Helicopters

I won’t pretend to fully understand the machinations of the Federal Reserve. It is operated by people with IQs that are probably three times what mine is.

But isn’t that part of the problem – that no one can really explain exactly how the Fed works? OK, that point aside, one thing is clear: the Fed has been supporting the housing market by buying trillions of dollars of mortgage backed securities. What happens if they have to sell them all? Isn’t that a lot like what happened to AIG?

At some point, and I don’t know when it will happen, but I would imagine that the Fed would have to stop buying mortgage backed securities and/or sell them. This FAQ section from the Fed dated August 5th, 2014 only serves to confuse me more — but if there’s something that confuses me, then it is probably confusing other people, too.

I don’t like that something so important and integral to single-family home prices is confusing to me. It makes me scared, and I think it is potentially the biggest risk to prices.

Conclusion

I am still an advocate of purchasing real estate, but I would caution people on being too aggressive. Make sure you can afford the investment through good times and bad. Have ample cash reserves or partner with an investor. Go through multiple scenarios of underwriting.

Can you afford for a property to be vacant for two months? What happens if you need to pay for a big capital expense, like a new roof? Plan, plan — and plan some more, my friends. Also, make sure to learn as much as you can about the aforementioned risks!

Which of these risks do you think is most prevalent? What would you add to my list?

Join in on the conversation below!

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About Author

Conor has experienced every aspect of the foreclosure and rental business for single-family homes. He was VP of Acquisitions at Silver Bay Realty Trust, and has flipped over 100 homes. Conor started a blog called Wall Street Slum Lord and is working on publishing his first novel.

12 Comments

I have noticed a loosening of lender guidelines lately with some lenders going down to 580 credit scores and Wells Fargo announced they will start up sub prime again. I also don’t think the buy-to-rent guys are big enough to make a dent in the US housing market except for localized markets. Even then they are smart people, they aren’t going to dump their inventory at once essentially chopping off their own foot. Those funds have tons of cash and they are worried about returns not so much running out of money. Numbers 3 and 4 are bigger questions. Nice article.

On Point 1: Banks believe that they can afford to make weaker loans when prices are going up, because the house will be worth more when they foreclose on it than the loan cost. When prices are going down, they stand to lose a lot of money when they foreclose. Of course, when the industry as whole gets too loose, they end up crashing the market and everyone else loses (Because Uncle Sam bails the banks out, not everyone else).

On Point 3: This could very easily be made anon-issue. When I bought my house two years ago, the underwriters refused to accept a letter from the Department of Education stating what my student loan payment actually was, but insisted on making up a number that was substantially higher than real life. It was stupid. If underwriters were to ‘loosen’ (in this case, use a sane) standard for calculating student loan debt, it would make this issue a lot less of a problem.

On point 4: The Federal Reserve is very easy to explain- they are smart, wealthy bankers who do their best to make themselves and their comrades wealthier. Any action they take, you can be sure is calculated to bring themselves (and their comrades) the most gain. Sometimes, that aligns well to the public interest, but often, it goes in opposition to the public interest.

I know I’m in the minority on this, but, in regards to Point 1, I think that the larger the loan then the bigger the risk.Take house X, for example. Say it is currently worth $100. All of a sudden prices go up 50% and it is worth $150. Instead of someone buying it and putting down $20, they now have to put down $30. More importantly the bank is lending $120 which seems riskier to me than lending $80 for the same house. Does that make sense? I may not have articulated my point very well.

Hi Connor,
You make some good points, and I have thought about some of those myself. To me, it appears the economy and real estate are still very fragile. So as investors what should do we? Are you saying we should buy and hold, but be careful?
I was going to start building my rental portfolio while prices are still low. Who wants to buy rentals when their over priced and you can’t get cash flow? It seems to me buy and hold would work. If the “want to be homeowners”, including students, can’t afford to buy houses, they have to live somewhere. They can’t count on mom and dad forever. Or can they? I’ll address that later. And, if the buy to rent funds sell off some houses that could be good for us, because we can pick them up cheap. Now, if demand for house rentals declines, then we could change some of our rentals over to purchases.
Unless our economy and individual debt forces us into living together in family communities, which is possible in the near future, I believe buy and hold, and doing some cautious fix and flip for good cash flow, will work for now. We will have to wait and see what these factors really bring and be ready to adapt.
Who knows maybe we will have to provide housing for family communities, just so people can afford to live somewhere. It might already be happening here. In fact, we probably all know of ones who lost their jobs during the recession and had to live with family or friends. It’s a way of life in other lands, and if conditions get worse, it could happen here.

Thanks for the comment, Don! Agreed that a cautious buy and hold strategy should work. My main point in this article is to be mindful of the risks. In today’s market prices are shooting up, but there are still some locations that you can get good cash flow and returns. I think you raise some good questions about the eventualities that many people could face: living with parents, being long term renters instead of buyers, and cheap rental communities. I’m not smart enough to know which will come to pass, but I think it’s a helpful and worthwhile exercise to think about the possibilities so we can better prepare ourselves to benefit from them.

Great article as now I feel more motivated to buy more properties before prices go up. I currently own 3 SFDs and feel there could be some positives to rising house prices and toght lending. Wouldn’t this be a recipe for a greater demand to rent? First time home buyers continue to be challenged in affording a payment on a loan that they can’t qualify for already. Does that make me a glass is 1/3 full R.E. investor?
Thanks, Dan

Dan – that seems like a reasonable outcome to me. The reality is that we are all just speculating about what could happen. My main point is to be aware of the risks and hopefully plan for them in case they occur. You should definitely patent the “glass is 1/3 full RE investor” line – I love it!

I would have to disagree with this list, most of these items are tiny compared to the real problem, I will get to that later.
#1 – I don’t believe this item has any place in the big picture (perhaps just a small factor), prices have leveled and some banks have already begun new loan programs (.more loose ones).
#2 – This one has no place on the list, in fact, they have not failed, but succeeded in their quest, though they thought they were going to have more than what they did. These homes are already being packaged up and sold off to unsuspecting securities purchasers, as pointed out, very similar to the MBS’s that practically brought down the economy last time. That is definitely a problem, however there is no feasible way girl all of these funds to dump all their homes at once and they hold a very small percentage of the us housing market.
#3 – This is a tiny brush stroke of the painting. More accurately, this item should just state – Debt. It is at nightmare proportions not just here in the US but globally. It will not be long before Greece goes BK, their recent bailout only delayed the inevitable. The fed reserve, controlled by the largest banks in the world, make all the rules and are printing money like it is going out of style. This will crush the value of the dollar and when you look at all the debt we have, national debt, student debt, secured debt, unsecured debt, we are living on borrowed time and time is about to catch up to us. That my friends is the #1 factor that will not only take down the RE market, but the stock market and world economy.
#4 – This is the most concerning and damaging item and I touched on it in item 3. For the most part, anything the government puts their grubby hands on turns out badly for us. It is the never ending story of bringing a rocket launcher to a fist fight.
I believe the stock market will go first and RE will follow, residential being the first class in that category. We could very well be in trouble within the next 5 years, maybe 10, I don’t know, I’m not that smart. What I do know is if things continue on the path they are on, that will be the result. The scary thing is that you can not just stock pile cash and sit on it as it will be losing value so you will have to find some vehicle to invest it in to hopefully keep up or outpace the loss of its value over time.

Could you expound upon your comment “we are living on borrowed time and time is about to catch up on us”? I think your “we” might be U.S individuals/country and “time is about to catch up on us” means you think the U.S. Economy will collapse?

#1 – I think you might be understating the potential significance of tightening lending standards. The percentage of all-cash buyers is dropping, which means that there will be an increasing number of buyers using debt going forward. If lending standards are tightened (obviously depends on how much) then this could certainly have a detrimental effect on pricing. We can debate whether or not that will happen, but if it does I don’t see a scenario where prices don’t go down.

#2 – I worked for Silver Bay Realty Trust (SBY) and know many of the other operators for the large funds. I will tell you affirmatively that they have not yet succeeded. Operating expense ratios are still very high, and vacancy is a constant issue. There is a very feasible way for these groups to sell all of their homes at once, and it is in a bulk-sale. There are portfolios of close to 1,000 homes on the market today, granted not many of them. You are right that they hold a very small percentage of the market, but they operate in very concentrated areas like Phoenix, Atlanta, Bay Area, Greater LA, Florida, and parts of Texas. While they may not be able to crash the overall real estate market, they can do meaningful damage to pretty big metropolises.

#3 – I agree with you. Point well made.

#4 – I wouldn’t be surprised to see the stock market sell off meaningfully, and real estate prices to go up, at least in the short term. Long term I agree with you. There is only so long that you can operate at a negative. As a good example, there is a celebration that the rate the debt is increasing is slowing down.

Eek, scary stuff. I agree with Barnard, debt is the real problem. I’m not sure I’ve bought off on the “total collasp” thinking, but we are definitely in for a substantial correction over the current state of affairs. Hold on tight!